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These Stocks Are As Cheap As It Gets, but Should You Buy?

Sometimes the key to smart investing is looking at industries others have shunned.

According to an analysis last month by Bloomberg and Leuthold Group, the cheapest stocks on the S&P 500 are, as a group, the banks.

Cheap is good if you think the underlying business is worth more than the market is pricing. On the other hand, cheap can be an indicator that the industry has serious and unresolved problems.

The question for the opportunistic value investor is what kind of "cheap" banks represent today. Is it time to buy, or is it time to run and hide?

Why are banks cheap today?According to the Bloomberg and Leuthold Group analysis, banks today trade at about 17.6 times trailing earnings. Overall, the S&P 500 trades at a price-to-earnings ratio of 18.8, slightly higher than the index's 10-year average and 38% below its all time high in 1999.

Banks have been much disparaged over the seven years following the onset of the financial crisis, a fact that helps explain their generally cheap valuation.

Beyond the bad public relations, though, investors today are concerned about real business issues: increased regulatory costs, higher capital requirements, and a general uncertainty over the industry's ability to manage risk and produce a consistent return.

The effects of these issues are obvious in a review of the industry's financial performance.

Using data from the FDIC's Quarterly Banking Profile, it's clear the industry today is struggling to match past performance.

Return on equity was routinely around 15% in the period following the savings-and-loan crisis in the late 1980s and early 1990s, yet today banks are struggling to produce ROE north of 10%. In the same way, return on assets was typically between 1.25% and 1.50% then, versus about 1% today. These lower returns are at the core of the banking industry's cheap valuation.

Hurricane-force headwindsIn the past, many banks have benefited from the use of massive amounts of debt to bolster return on equity, particularly for the investment banks. But the Basel and Dodd-Frank regulations have curtailed that practice.

Today, the Internet, mobile banking, and even regulation have allowed new and nimble companies to enter the marketplace to challenge the established banking players. Peer-to-peer lender LendingClub, for example, raised $870 million in its IPO late last year, a strong signal that investors and consumers are open to supporting banking services from non-bank providers.

At the same time, banks are being forced to spend millions upon millions of dollars to expand regulatory compliance programs set forth in new legislation such as Dodd-Frank. M&T Bank CEO Robert Wilmers wrote in his 2014 letter to shareholders that the bank spent $266 million in new regulatory obligations in 2014 alone, an "unprecedented amount in unprecedented times."

M&T's experience is not unique; these regulatory costs are having a material impact on returns throughout the industry.

Can banks once again find success?For banks to be a good value investment today, then something must change to push the industry back to the returns on equity and assets seen in the past.

In spite of all the headwinds, there is one huge factor that could drive bank profits and valuations higher: the normalization of interest rates.

Banks make money by accepting low-cost deposits from customers and then investing that money as loans, charging a higher interest rate. The difference between the cost of the deposits and the interest charged on the loans is the main driver of bank income.

It's the nature of the interest rates that loan prices will rise faster than deposit costs, meaning that a rate increase from the Federal Reserve will directly boost the bottom line of most banks.

That means the past seven years of generationally low interest rates has been a major drag on bank earnings, and it also means a return to normality should give the banks a strong boost to the top and bottom lines.

JPMorgan Chase, for example, projects that a normalization of interest rates between now and 2017 would boost its earnings power by about $4.5 billion per year. Based on the bank's year-end 2014 net income of $22 billion, rate normalization alone could boost the bank's earning power by 20.5%!

Now's a great time to buy great, fairly valued banksGiven the serious headwinds facing the industry, my view is that today's discounted prices are, in general, warranted. However, now is a great time to take advantage of discounted prices to buy strong banks for cheap or fair values.

The key to doing that is to find banks with above-peer returns on equity and assets, have a history of strong performance in past recessions and expansions alike, and possess management teams that focus relentlessly on keeping costs down.

If you find a bank that matches those criteria, odds are you've found a pretty good opportunity.